As the world grapples with profound social and economic challenges, the need for innovative financial solutions has never been more pressing. Among these solutions, social bonds have emerged as a powerful tool for financing social projects that aim to address social issues such as poverty, healthcare, education, and affordable housing. Social bonds represent a dynamic intersection of finance and social impact, facilitating the flow of capital to initiatives designed to foster positive outcomes for society.
The principles
The International Capital Market Association (ICMA) defines social bonds as any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible projects with clear social benefits – i.e., classification as a “social bond” is project driven and arises from the (social) purpose of the financing.
To help issuers structure credible social bonds and to promote market integrity, ICMA issued the Social Bond Principles (SBP), emphasising four core components:
1. Use of proceeds: As the cornerstone of a social bond, the proceeds must be exclusively applied to eligible social projects, addressing areas such as affordable basic infrastructure, access to essential services (e.g., healthcare, education), affordable housing, job creation, food security, and socio-economic advancement.
2. Process for project evaluation and selection: Issuers must outline and disclose the decision-making processes used to determine the eligibility of social projects, including the project’s selection criteria and sustainability objectives.
3. Management of proceeds: The net proceeds of social bonds must be credited to a specific account and tracked by the issuer in a transparent manner, based on formal internal processes.
4. Reporting: Issuers are required to provide annual updates on the use of proceeds, detailing the allocation of funds and the expected social impact, based on qualitative and quantitative performance measures.
Furthermore, ICMA recommends that issuers (i) explain the alignment of their social bonds with the SBP by publishing their own Social Bond Framework, easily accessible to investors; and (ii) appoint external reviewers, to assess compliance with the SBP and the tracking of the use of proceeds, both prior and post issuance.
The tax framework
Portuguese tax law does not specifically address the taxation of social bonds. Instead, the tax treatment of social bonds falls under the general tax regime applicable to debt instruments. Social bonds, like traditional bonds, can generate two main types of income for investors:
- Interest payments, determined based on the pre-agreed remuneration conditions; and
- Capital gains, which may arise either from selling social bonds at a profit or from the difference between the acquisition cost and the redemption value when bonds are purchased below their par value in the secondary market.
Portuguese resident investors are subject to tax on this income in accordance with the general rules, regardless of the specific nature of the bonds.
In recognition of the importance of attracting alternative financing for Portuguese entities, there is a special tax regime (the Portuguese Special Debt Securities Tax Regime) for interest and capital gains derived from Portuguese public and private debt securities applicable to non-resident investors without a permanent establishment in Portugal, provided certain conditions and formalities are met.
Given the profound impact social bonds can have in promoting important social projects, they should benefit from a clear tax-favoured regime to enhance their attractiveness. Inspired by the Special Debt Securities Tax Regime, a full exemption from corporate income tax/personal income tax could be considered for income obtained by (both resident and non-resident) investors in social bonds.
The market
Since the first social impact bond was issued back in 2010 in the UK (aimed at reducing recidivism among short-term prisoners in Peterborough), the social bonds market has shown significant growth and development worldwide. However, the Portuguese social bonds market has developed more slowly, with the first reported issuance of social bonds in Portugal, by Casa Mendes Gonçalves, having only occurred last year. The proceeds from this bond issue were fully used to purchase and renovate housing for refugees, migrants and workers starting their first job with one of the companies of the group.
Notwithstanding the above, it is worth mentioning that, in Portugal, the issue of sustainability-linked bonds – whose proceeds, differently from social bonds, are applied to promoting social goals within the issuer’s corporate structure – is significantly more common.
The impact
It is easy to understand how social bonds relate to the increasingly prominent Environmental, Social, and Governance (ESG) framework, particularly its social component. This type of bond allows for direct investment in social projects and, consequently, the issuer’s promotion of responsible and sustainable investment practices aligned with social values, creating confidence among investors about the positive social impact of their investment and effectively implementing social change and improvement in the area of execution of the project.
From the outset, an issue of social bonds aims to allocate funds to projects focused on resolving pressing issues in society – nevertheless, such allocation may also (even if indirectly) be interesting from an issuer’s perspective.
If we consider the example of lack of affordable housing in a certain area of the country where an issuer intends to create a hub or where one already exists (but the high cost of housing hinders the hiring of workers), it is clear how a social bond can contribute to both the construction of affordable houses and the retention of workers by the issuer. The problem of interior desertification can be similarly tackled. Many inhabitants of the interior of Portugal move to coastal regions due to the availability of better support infrastructures (such as hospitals and schools). Thus, if the proceeds of an issue are allocated to the development of these infrastructures, this migration may become less evident, with potential advantages for issuers located in remote areas.
These are only two examples of social problems existing in Portugal that could be addressed through social bonds, and which allow us to better understand the potential impact of this type of investment from both a social and business perspective.
The future
Despite the growth and positive impacts of social bonds, the market faces several challenges. One of the primary issues is the need for rigorous impact measurement and reporting. Metrics and methodologies have been developed, but it can still be difficult for investors to assess the true social impact of their investments. Moreover, there is the challenge of balancing the dual mandate of financial return and social impact. Given the unique nature of the types of projects eligible for social bonds, creating a special tax regime for these instruments could make them more attractive and encourage greater investment in socially impactful projects.
Nevertheless, the future of social bonds appears promising. As awareness of social issues continues to grow, with an increasing emphasis on ESG criteria, the demand for social bonds among investors is likely to rise. The advent of blended finance, which combines public, private, and philanthropic capital, also holds potential for expanding the reach and impact of social bonds.
Social bonds further represent an exceptional opportunity for non-profits to diversify their funding sources and move away from full reliance on public funding and/or patrons (which tend to be highly unpredictable and short-term oriented). The use of social bonds effectively enables the participation of investors with different profiles, thereby enhancing the footprint of non-profit entities and allowing them to obtain financing for projects that would otherwise be difficult to pursue, due to the significant financial effort required or long-term implementation timeline.
Considering that non-profits generally focus their activities on pursuing social goals, this synergy between their mission and the issue of social bonds seems natural. However, their active involvement represents both an opportunity and a challenge, since the Portuguese regulatory landscape does not seamlessly accommodate the issue of social bonds by non-profits and, therefore, the first entities to explore this alternative will be paving the way and establishing a market standard for the future.
In a nutshell
Social bonds represent a transformative financial innovation that aligns capital markets with the pressing social needs of our time. Guided by ICMA’s SBP and bolstered by significant market milestones, social bonds have rapidly evolved from a niche product to an important component of the investment landscape. They exemplify the potential of finance to drive positive social change while delivering financial returns to investors and, as the market continues to mature, they stand to play an increasingly crucial role in addressing global social challenges, promoting sustainable development and offering non-profits an alternative long-term funding option
